The impact of government contracts on the structure of corporate transactions

August 2016 | PROFESSIONAL INSIGHT | MERGERS & ACQUISITIONS

Financier Worldwide Magazine

August 2016 Issue

Many considerations, principally tax implications and retention of liabilities, influence the form of a corporate transaction, e.g., a stock purchase versus an asset transaction. When the transaction involves government contractors, however, other considerations are also important. This article identifies the government contracts issues relevant to transaction structure so that they can be taken into account as part of the overall evaluation of the structure and not become an eleventh hour surprise for dealmakers anxious to close and put the transaction to bed.

So, with that prologue, why does it matter, from a government contracts perspective, what form the deal takes? The answer to this question can be found in two federal statutes, i.e., 41 U.S.C. § 6305 (formerly 41 U.S.C. § 15) and 31 U.S.C. § 3727, which prohibit, respectively, the transfer of government contracts, or of interests in government contracts, and the assignment of claims and interests in claims against the government. There are several reasons for these statutes, including to discourage speculation in government contracts that can then be ‘flipped’ for profit after award; to make sure that the government knows with whom it is dealing and that it obtains the benefits anticipated when it chose the contractor in the first instance; and to avoid duplicative claims and payments under the contracts.

If these anti-assignment statutes apply to the transaction, the government will have the right to approve of the transfer of contracts affected under the deal and treat the acquirer/assignee as the successor-in-interest to the prior contractor. By the same token, if a prohibited transfer takes place without the required government consent it “annuls the contract or order”. 41 U.S.C. § 6305(a). Under the Federal Acquisition Regulation (FAR), absent the required government consent, “the original contractor remains under contractual obligation to the Government, and the contract may be terminated for reasons of default, should the original contractor not perform”. FAR 42.1204(c). Needless to say, this is not the kind of post-closing development that will be warmly welcomed by the buyer, whose initial notice of the problem may come when the government declines to pay invoices submitted by a ‘stranger’ to the contract.

It becomes important, thus, to know what transactions are subject to the anti-assignment statutes, and therefore require government consent, and which are not. The answer is not always altogether clear.

Stock purchases. Acquisitions made by way of a stock purchase should not implicate the anti-assignment statutes. The entity in privity of contract with the government does not change; the only change is in the identity of the shareholders. Because the contracts will be performed by the same entity, utilising the same facilities, assets, personnel, skills and experience applied by the acquired entity before the stock purchase, this type of transaction does not implicate any of the policy reasons that underlay the anti-assignment statutes. Although there is no case that actually squarely so holds, the FAR expressly excepts stock purchases from the requirement for government consent.

Asset purchases. The FAR identifies a sale of assets as a transaction that requires government consent. This makes sense if one examines the policy reasons for the anti-assignment statutes – the performing entity is no longer the entity to which the contract was awarded in the first instance and the prospect of conflicting claims and misdirected payments is obvious. The case law uniformly recognises the government’s approval rights in connection with asset transactions. The types of asset sales that will be favourably considered for consent by the government generally include the sale of all of the assets of the original contractor, or the sale of all of its assets involved in performing the contract, with a provision for the assumption by the acquiring entity of the liabilities associated with the acquired contracts. The government will not want to chase an entity with which it no longer has privity of contract to enforce liabilities not assumed by the new contractor.

Mergers and consolidations.Up until now, the answers have been fairly straightforward, with predictable outcomes. This is where the road gets curvy, hilly and bumpy. A number of cases hold that a merger or consolidation affects a transfer of assets ‘by operation of law’, and, therefore, that that such transactions are not subject to the anti-assignment statutes. Unfortunately, the FAR provides that consent is required for a transfer of assets “incident to a merger or corporate consolidation”. While one might assume that the US Supreme Court trumps the FAR, contracting officers do not necessarily subscribe to that view and, in the world of government contracting, they rule the roost.

While one can occasionally encounter a contracting officer who will actually listen on this score, and there are cases holding that a reverse triangular merger is not subject to the anti-assignment statutes, most contracting officers will adopt a reflexive response that they must comply with the FAR as written. When this happens, despite the parties’ compelling legal arguments for the inapplicability of the statutes, there is no way effectively to resolve the issue in advance of closing and the course almost invariably charted by the parties is to: (i) advise the contracting officer of the transaction; (ii) seek agreement that a novation is not necessary; (iii) failing that (as will usually be the case) precondition him or her so that consent can be readily obtained promptly after closing; and (iv) bemoan in private the FAR’s reversal of Supreme Court precedent.

Incorporation of a proprietorship or partnership or formation of a partnership. The FAR clearly requires consent, which makes sense in light of the problems that the anti-assignment statutes are designed to avoid. The transaction creates a different legal entity and the government’s recourse in the event of performance problems may be radically different.

Restructures and reincorporations. “[B]usiness restructurings, such as reincorporation, which involve no change in ownership of the business” are regarded as transfers by operation of law that are not subject to the consent requirements of the anti-assignment statutes. Once the reorganisation involves changes in ownership, the need for government consent becomes an issue.

Assignments in bankruptcy. The question here is whether the assumption of an executory government contract by the debtor in possession is a prohibited transfer that is subject to the government’s consent prerogatives. This involves the intersection of the anti-assignment statutes and 11 U.S.C. § 365(c)(1). This latter statute provides that the “trustee may not assume... any executory contract... if... applicable law... excuses a party... to such contract... from accepting performance from... an entity other than the debtor or debtor in possession…”

Unfortunately, there are cases that come down on both sides here, holding in contradictory fashion that: (i) Section 365(c)(1) does not prohibit a debtor in possession from assuming an executory contract, with or without the other party’s consent; and (ii) a debtor in possession cannot assume an executory contract if applicable law would prohibit an assignment to a hypothetical third party. These cases proceed on the assumption that “a solvent contractor and an insolvent debtor in possession going through bankruptcy are materially distinct entities”. Under these latter cases, thus, the government can exercise its consent rights under the anti-assignment statutes to block the assumption of the contract by the debtor in possession.

Before closing, let us focus for a moment on pending bids and proposals. There is nothing in the anti-assignment statutes that mentions bids and proposals, which obviously are not ‘contracts’ and are clearly pre-contractual in nature. Nonetheless, the FAR incorporates the basic principles outlined above, which empower contracting officers to reject bids and proposals that have been ‘transferred’.

John Chierichella and Keith Szeliga are partners at Sheppard, Mullin, Richter & Hampton. Mr Chierichella can be contacted on +1 (202) 747 1903 or by email: jchierichella@sheppardmullin.com. Mr Szeliga can be contacted on +1 (202) 747 1927 or by email: kszeliga@sheppardmullin.com.